Passive investing – replicating the market’s returns through low-cost index funds or exchange-traded funds (ETFs) – has finally gained a meaningful share of the market. However there are still many investors who attempt to beat the market by investing with higher-fee active investment managers or directly in individual securities. These investors should fully consider the difficulty of achieving a superior result through active investing, and be aware of the behavioral biases that might be driving them down that path even when their circumstances might make passive investing a better alternative.

Why am I, an active value investor, making this argument?

I believe that one reason that passive investing has not seen wider adoption is the imbalance of marketing forces aligned against it. The active investing industry spends substantial sums on advertising itself to potential clients – an amount firms offering low-cost index funds rarely have the means or the incentives to match. Furthermore, investors’ behavioral biases are likely causing them to discount the data and overestimate their own abilities to do better than most through active investing. For an overview of behavioral biases and how to defend against them, please see my previous article titled Behavioral Defense in Decision Making.

While having an investor lacking the expertise to truly assess a manager’s process might lead to profits for some active investment managers, it is unlikely to lead to an outcome for the investor that is superior to investing through a low-cost passive index or ETF. If the marketplace were to replace managers who are producing mediocre results with the much cheaper passive alternatives, this would likely benefit both investors as a group and those investment managers who have the process, expertise and temperament to generate superior long-term returns. Investors will be better off if the market evolves to a much smaller active investing industry with clients able to look beyond short-term results to judge their investment managers on process.

The case for passive investing

A substantial majority of professional active investors have underperformed the index over the long term. For example, the S&P 500 index has beaten over 75% of active funds that invest in large stocks over the last decade. 1 The magnitude of underperformance of most mutual funds is even greater when considered on an after-tax basis, which is relevant for a number of investors with taxable accounts. This is due to the fact that most active strategies have much higher portfolio turnover than the typical index, resulting in lower tax efficiency. The long-term experience of an investor in the average “hedge fund” has been uninspiring at best. 2 These vehicles, which frequently carry much higher fees, have on average failed to generate attractive long-term returns – other than for their managers. These facts lead me to conclude that the base-rate probability of an active investor beating the market is low.

It is difficult to determine in advance which investment managers will achieve superior returns. Some might think that it doesn’t matter if the majority of active investment managers underperform, because they are going to invest with one of the few who are going to do much better than the market. Unfortunately, this has proven to be an elusive goal for most; it is challenging to determine who will be among the small percentage of investors that will beat the market. Consider that:

Studies have shown that short-term performance has little predictive information about future performance. 3 However, it is common practice among active investment managers to use short-term historical performance to help sell their services.

A recent study of Morningstar ratings concluded that there was little evidence that selecting 5- and 4- star mutual funds allows its users to pick equity funds that perform meaningfully better than the market. 4 Keep this in mind the next time you see an ad touting the number of stars a fund has.

The average mutual fund investor has underperformed the average mutual fund by more than 2.5% per year. 5 The magnitude of this underperformance dwarfs the magnitude of the underperformance of the average mutual fund relative to the index. In other words, the typical mutual fund investor has not only failed to add value through the process of attempting to pick future winners, but has in practice exercised reverse timing – the “art” of doing today what they should have done yesterday. This happens due to investors flocking to funds after a good short-term performance stretch and redeeming after a poor one.

Most investors lack the expertise required to assess an investment manager based on process, making them susceptible to behavioral biases and marketing tactics that can be detrimental to their investment outcome. Perhaps you still believe that the low base-rate probability of adding value through active investing will not prevent you from succeeding where many others have failed. I propose the following checklist to help you gauge whether you have a process that is likely to beat the odds:

If you were not allowed to know anything about a manager’s past performance, what factors would you consider, and how would you use them to determine if a manager is likely to deliver superior future results?

Imagine you have invested with an active manager for the last 3 years during which the manager has underperformed the index. What will your process be for determining whether to redeem, do nothing, or invest more with that manager? Recall that many investors exercise reverse timing by redeeming from managers with recent underperformance and investing with managers who have recently done well, contributing to the poor results of those investing with active managers.

Imagine that you were not allowed to look at the performance of a manager after you invested. How would you assess whether the manager is following the investment process that you were sold on when you initially invested?

If some of these questions sound too difficult in the abstract, and perhaps even more difficult in real-time under the influence of market gyrations, that is a good indicator that you should consider a passive investing approach.

Am I telling you that you should only invest through low-cost passive index funds or ETFs? No, that is for you to decide based on your own circumstances. What I am telling you is that a lot of others who have tried beating the market through active investing have not succeeded, despite thinking that they would at the outset. Before you deviate from passive investing, which I believe should be your default investment strategy, carefully consider whether you have the expertise to do so, and only deviate if the answer is a clear, “Yes, I have the expertise.”

Endnotes

1 Source: www.morningstar.com; Estimated by taking the 10-year Rank in the Large Blend category of the Vanguard 500 Index Fund (VFINX) as of 2/24/2017 (22%), which likely understates the rank due to survivorship bias.
2 According to a recent academic paper, the average hedge fund produced an annualized return of 6.3% when adjusting the data for survivorship and backfill biases. “Hedge Funds:
A Dynamic Industry In Transition”, Mila Getmansky, Peter A. Lee, and Andrew W. Lo,https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2637007

4 The average 5-star equity fund beat the average 3-star fund by ~ 0.6% per year at a statistical significance level that failed to meet the typical threshold for such tests. When taking into account that an index fund likely beat the average 3-star fund by a similar amount during the period under consideration due to the active funds’ higher fees, it is not unreasonable to conclude that the average 5-star equity fund failed to measurably beat the index. Source: “Does the Star Rating for Funds Predict Future Performance?”, Jeffrey Pak and Lee Davidson,http://news.morningstar.com/articlenet/article.aspx?id=780965

5
This is due to investors typically buying funds after recent short-term good performance and selling them after poor recent short-term performance. In “The Little Book of Common Sense Investing” by John C. Bogle, Bogle provides data that shows that during the 1980-2005 period, the average investor in equity mutual funds underperformed the average mutual fund by 2.7% per year. According to recent data from Blackrock ( https://www.blackrock.com/investing/literature/investor-education/investing-and-emotions-one-pager-va-us.pdf) that spread might be even larger.